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Of We Go Again, Ready, Set……….

After a weekend of semantic analysis the currency markets didn’t take long getting back to work – the euro was only a cent off its all time high by late morning. According to Dictionary.com the relevant meaning of volatility is: tending to vary often or widely, as in price – the ups and downs of volatile stocks. Not much danger of volatility here, not if the only way the dollar is going to go is down. Wouldn’t the more appropriate term have been secular decline? But maybe they aren’t against that, and the markets in turning the pressure back on the dollar, have read the signal exactly right.
In fact relative currency values are being driven principally at present by US economic data. As such I can’t see that changing. Employment, productivity, current account, federal deficit: all of these will, in the end, speak louder than any words. Since I am definitely bearish in my leanings as to how these will go, I have to imagine that the dollar will continue to fall, and the euro to rise.

However when it comes to the current European and Japanese ‘recoveries’ there is no getting away from the fact that part of the driving mechanism is currency movement. If the dollar is going down, then the euro and the yen are going up. This makes euroland and Japanese stocks attractive whatever the valuation put on the economic performance of the various regions. People anticipate that Japanese and European financial assets will continue to rise and that is why a lot of US money is going into the EU and Japan.

This is having a virtuous circle effect, and giving a fair bit of a push to recovery ‘especially in Japan’.

But here is where the economic theory inevitably kicks-in. There are two questions, the business cycle, and the financial architecture.

Firstly the markets are optimistic – I wouldn’t describe it as exactly a bull – since they apply standard business cycle theory, make a trend line, and imagine things must be on the up and up.

I don’t accept this reading, I think that too many historic linkages are ‘broken’ and we cannot be sure of very much. If I am right and the ‘recovery’ doesn’t come in the expected fashion in France and Germany, then there will be a correction.

Second issue: financial architecture. As I keep stressing we have a structural problem that was always there waiting to appear. Having one of the currencies as numeraire (the basis for valuation of all the rest, or put differently, the reserve currency) – in this case the dollar – was always going to present enormous difficulties if we had to do global rebalancing. Now, with the rise of the new economic powers in Asia there is no alternative but to accept the inevitability of the change. If it happens at a trickle rate, then just possibly there is no big deal. But if there is a rush for the door at some stage, then there is a big deal. That is what everyone is worrying about.

My feeling is that the euro cannot stand the high valuations which are going to be loaded on it, at least not without a large dose of internal deflation, and this would be very painful for other reasons.

So at some stage, the euro may drop significantly, or even worse crack at the seams, and at that moment the money will come out again, and maybe all of a sudden, as people again try to stay in the currency shift anticipation business. So let’s be clear: the risk here is not only of a sudden and destabilising fall in the value of the dollar, other currencies are at risk, and the possibility of this eventuality should give everyone plenty of cause for thought.

The Japanese government on Monday sought to portray the result of Group of Seven finance ministers meeting in Florida as a victory, while investors took a muted warning about “excess volatility” as an acceptance of a weaker dollar.

Yasuo Fukuda, Japan’s chief cabinet secretary, said: ?It was good in that it confirmed the shared view that exchange rate stability was important.?

Japan has spent unprecedented amounts on foreign currency intervention with the supposed intention of smoothing out sudden movements, rather than keeping the yen artificially low. Last year, it spent Y20,000bn and in January lavished a further Y7,155bn.

Jesper Koll, economist at Merrill Lynch in Tokyo, agreed with Mr Fukuda?s assessment of the Florida meeting, saying the G7 had ?turned Japanese?.

The dollar fell to fresh two-week lows against the euro and came under pressure against the yen on Monday as investors took the muted weekend warning from the G7 as a tacit acceptance of a weaker dollar.

Initially, the dollar rose sharply, and the euro slid to $1.2605 early in Asian trading from $1.268 late in New York on Friday. But by late morning in Europe, the single currency had climbed steadily to a peak of $1.2761, its highest in more than two weeks and little more than a cent off the $1.2898 lifetime high it reached in January.

Sterling reached a new 11-year high against the dollar on Monday at $1.8628.

The statement from the Group of Seven finance ministers and central bank governors said: “Excess volatility and disorderly movements in exchange rates are undesirable for economic growth.”

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro.
By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

Actually, the drop in the dollar is more about a drive by the Fed to avoid deflation in my book. Although obviously there are various motivating factors, including the current account deficit.

Obviously, on opinions for the future: to each his own. But since I see the US as fundamentally healthier economically than Europe and Japan, I can’t buy the Yen/Euro rise which seems to be the logical corrolary of the dollar fall. My impression is that US economists understand what is happening much better than the European ones: with a few honourable exceptions of course (try reading the Economist’s Buttonwood).

I consider the european fiscal problem orders of magnitude bigger than the US one, the US has some remedy: reverse the tax cuts, and raise taxes. This ‘remedy’ is amuch more difficult to swallow in an already highly taxed Europe. US demographics are much better too.

Then there is global labour arbitrage (see Stephen Roach). The US is having problems now precisely because they are getting to grips with this. Europe has yet to seriously confront the problem, but the point of my ‘globalise or die’ thing is that it will come.

Ok, no-one has ownership to the truth here. These are just opinions. Later this year we will be a bit clearer about which of these scenarios is nearer to the reality.

It doesn’t seem so long ago that David was complaining about too many Iraq and Howard Dean posts (oh Howard, wherefore art thou? How time flies). Now I fear he will be on at me about too many euro ones. In an effort to keep this under control, maybe I should learn to use the quick links. Meantime an update for the comments section. From Bloomberg this morning:

“The euro strengthened for a second day in Asia after European finance ministers said they didn’t discuss currency sales as a way to stem a rally that is eroding demand for the region’s exports.

Finance ministers meeting in Brussels yesterday said they were banking on the Group of Seven’s condemnation of “excess volatility” to tame the euro’s rise against the dollar. Selling the euro “is not an issue on the table,” Belgian Finance Minister Didier Reynders told reporters before the meeting.”

“European officials sounded pretty pleased with themselves and content with the level of the euro,” said Robert Rennie, currency strategist in Sydney at Westpac Banking Corp. “The market is going to keep pushing up the euro, testing just how long Europe remains happy with it.”

As of 2:54 p.m. in Tokyo, the euro rose to $1.2743 from $1.2700 late yesterday in New York, according to EBS prices. The European currency was also at 134.47 yen from 134.11. The euro may rise to $1.30 in the next few weeks, Rennie said.”

My feeling is $1.30 and then some. As I keep saying, this is largely US data driven, and especially by the problems in the ‘soft’ labour market there. So only two questions: what value will be considered to be ‘too high’, and when we reach that point, what will be the plan?

Hmmm… I’m not quite sure what to think, but I think that I ought to think something. I’m a bit more immediately affected by exchange rates than most folks, since I earn money in euros, in a business that is structurally protected from overseas competition, while I have debts in dollars. The strong euro/weak dollar is definitely to my immediate advantage, while a catastrophic shift against the euro is not.

One of the more practical bits of knowledge that my branch of linguistics teaches is to be critical of the metaphors that underlie discourse. This makes it damn dear impossible to read the business press because economic analysis is always couched in poorly rooted metaphors. That means I’m not quite sure what makes the US economy healthier than the European one. Europe certainly has labour available to hire and capital is, as you point out, pouring in due to the high euro. Undervaluing a currency is an effective way of creating exports, but running a trade surplus is, on the long run, effectively a transfer of capital to states with trade deficits.

The US also has a good deal of underutilised labour milling around, but if your account is accurate it’s facing capital flight. Under the Bush administration, American deficits as a percentage of GDP are certainly just as high as Europe’s and personal debt is vastly higher.

I suppose there is a simpler remedy available to the US – dispose of George W Bush – than Europe. But I’m not sure that’s enough to stem capital flight, deficits or high personal debt. Europe, on the other hand, seems well positioned to lower interest rates and I have the impression that that’s what everyone expects Trichet to do. If there is strong demand for European securities, then they don’t need nearly as high interest rates to keep capital in the market, right? Lower interest rates are certainly a very critical factor in business development, and lower interest payments on public debts free up state capital to spend or to reduce taxes. If France and Germany lose in the ECJ for breaking the stability pact – and then actually accept the judgment and cut spending or raise taxes – this certainly minimises the risk that European governments will take advantage of lower interest rates to run up new deficits. It seems to me that the remedies avaiable to Europe are at least as attainable as those available to the US.

My biggest frustration with economics is that the more I think I understand, the less it makes sense.

More from Bloomberg. I am posting these updates because I entertain the vain hope that people may take note and remember who was saying what here:

“The euro climbed for a third day in four in New York as European Central Bank Chief Economist Otmar Issing and the region’s finance ministers suggested the bank won’t sell euros to stem a two-year rally.

Euro gains help slow inflation, and “there is no point in unleashing a short burst of fire,” Issing, one of the bank’s 18 policy makers, told the German newspaper Sueddeutsche Zeitung. European finance ministers meeting in Brussels said they won’t push the ECB to sell euros.

Finance officials “haven’t shown too much displeasure over the euro’s rise,” which has taken it 46 percent higher in the past two years, said Tim Mazanec, senior currency strategist at Investors Bank & Trust in Boston, which is custodian for $1.1 trillion in assets. “It’s just a matter of time before the euro makes new highs.”

“Traders bid up the euro as European finance ministers including Austria’s Karl-Heinz Grasser and Spain’s Rodrigo Rato said no action is needed beyond Saturday’s Group of Seven condemnation of “excess volatility” in exchange rates.”

““The effect of a further euro appreciation on growth would be just minor,” Grasser said on the second day of a meeting of European Union ministers in Brussels.”

““A strong and stable euro is good for Europe,” Spain’s Rato said as he arrived in Brussels.”

Of course I’m not saying there is much to be done. We are effectively pretty much impotent. But I wouldn’t be calling the weekend’s G7 satisfactory, nor would I be expressing satisfaction with what is happening.

I will tell you all what I really think when we get to see Germany’s end-of-year inflation (deflation??) and growth numbers.

Gold bug checking in here, if only to give you guys someone to beat up on. Edward, you’re the only commentator I’ve run across who isn’t a gold bug who realized that having the de facto standard currency be a fiat currency is a big problem. My reasons would differ somewhat from yours, nevertheless, it’s pretty obviously a problem. Also of course I’d agree with your big drop scenario, ’cause us guys are certain that all the paper currencies are going to go up in smoke sooner or later anyway.
But back to Earth: to me it seems that the WTO should make massive interventions like those of the BOJ illegal. Basically, if you’re a member of the WTO you shouldn’t be allowed to do what they’re doing.
Also, I’m a bit confused, or maybe just misinformed re the Eurozone’s reaction to all this. I got the distinct impression that the European authorities had decided that the Japanese had proven that intervention does work to some extent, and were not averse to trying some on their own. Was I just plain wrong?

No I’m not a gold buff I’m afraid. I was brought up on the debate about the gold standard and its problems. I have no ‘handy in my pocket solution’, but I do think we should be looking urgently at this issue.

The proposal Paul Davidson gave to the G23 finance ministers in 1999 would be a good starting point. Summary here:

As long as the US doesn’t stabilise this situation, deflationary pressures will prevail, and the dollar will continue to fall. How then does anyone put a ceiling on the euro? Good question. The Japanese – as Paul indicates – are printing plenty of money, but to little effect. The ECB can do likewise, although I think there are problems in the regulations here, especially if you think inflation and not deflation is the problem.

OTOH, Bernanke is committed to unconventional measures if needed, among these would be printing money to buy non dollar assets – eg Euro or Yen denominated government debt. So we could have a buying/selling war, depending on how you look at it.

“The euro rose in London after European finance ministers yesterday said they wouldn’t push their central bank to sell the currency, which gained 18 percent against the dollar in the past year.

As of 6:38 a.m. in London, the euro climbed to $1.2702 from $1.2672 late yesterday in New York, according to EBS prices. It gained to 133.99 yen from 133.79.

“The prospect of intervention only becomes likely if the euro pushed up above $1.40,” Claudio Piron, currency strategist in Singapore at Standard Chartered Plc, said in a television interview with Bloomberg News. “The ECB’s policy is very conservative.” Standard Chartered forecasts the euro will rise to $1.40 by June.”

About 50 percent of the company’s sales and as much as 80 percent of its financial expenses are in dollars or “dollar- related” currencies, Hommen said. ”

A U.S. jobs report on Friday lowered expectations the Fed will raise interest rates soon, and any indication from Greenspan reinforcing that view will send the dollar lower, said analysts including State Street’s Kalirai.

“I expect him to stress what `patient’ means, and what that means is rates aren’t going up anytime soon,” Kalirai said. “The trend is going to continue for the dollar to go down as assets flow into higher-yielding areas.”

The failure by the G-7 to make explicit mention of the dollar’s decline may extend its slide, German government economic adviser Peter Bofinger said yesterday.

“It’s a shining example of indecision,” said Bofinger, who will join Chancellor Gerhard Schroeder’s panel of economic advisers, known as the Five Wise Men, on March 1, in a televised interview with Bloomberg News in Berlin. “I wouldn’t be surprised if the dollar’s drop continues.”

Interesting article by Davidson. Amusingly – or maybe not – we seem to be seeing #6 subsection 3 in action, with Japan spending massive sums to buy up US debt and thereby in effect engaging in a massive aid program for the US. Wolf makes this point in his column in today’s FT. (Yesterday’s, by the time you read this comment I’m sure.)